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The repeal of the Glass-Steagall Act and the deregulation of banking in the past few decades has been part of an overall effort to create a banking system that's monitored by the invisible hand of free market capitalism. Now, in the midst of one of the worst financial crises in U.S. history, there are calls for there to be free market solutions to the current problems.

My take: hogwash.

Dance around it as much as you like, the U.S. banking system is not a free market system. As a result, efforts to free up banks to do whatever they like have only allowed insiders to profit while the rest of the country bears the risks.

Free market, my tuchus
U.S. banks are part of a system orchestrated by the Federal Reserve Banks. The Fed is a quasigovernment entity that has the power to expand and contract the money supply of the country by buying and selling Treasury securities, fiddling with banking reserves, and lending through its discount window.

Basically, all of the interest rates in the U.S. are driven by the federal funds rate -- the interest rate at which banks lend each other funds overnight -- which the Fed controls by buying and selling Treasuries to set money supply at a level that achieves its interest rate target.

Furthermore, banks all over the country -- whether you're big, bad Citigroup (NYSE: C  ) , Regions Financial (NYSE: RF  ) , or little ol' State Bank of Leon -- have their deposits backed by the Federal Deposit Insurance Corp., which, in turn, is backed by "the full faith and credit of the United States government."

In short, the price of the key ingredient in the business of banking (capital) is controlled by the government, and the government also provides explicit financial backing for these institutions.

Which part of this system sounds like the free market?

Banks gone wild
What the U.S. banking system should be is a group of quasiprivate institutions that are part of the Federal Reserve System and whose primary task is to provide business and consumer loans and a safe place for money to be deposited. Shareholders should certainly be compensated, but owning a bank should be akin to owning a utility.

What the industry has become, though, is a consortium of institutions that use their access to cheap funding and government backstops as rocket fuel for increasingly risky operations. This is particularly true on the larger end of the spectrum, where the likes of JPMorgan Chase (NYSE: JPM  ) , Wells Fargo (NYSE: WFC  ) , and Bank of America (NYSE: BAC  ) rule.

The fact that Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) -- which have gnat-sized banking operations compared to their trading arms -- are now bank holding companies is a joke on the entire system.

The reason we should all be wailing about this is that the executives and traders at the major banks are taking home billions in bonus money while we're all stuck with the systemic instability and the check when things go wrong.

What the world needs now
Now I know there are folks out there nodding their heads, saying, "Yeah, darn right, there's no free market as long as the Fed is around. The Fed needs to be taken out back and shot!" I'm sorry to say this, but even if I thought that abolishing the Fed was a good idea (I don't), or that gold makes a good currency (it doesn't), Ron Paul and his small guerilla army just aren't going to get it done.

What I'd much rather see is the major banking institutions stripped down so that they are just that -- banking institutions. And if Goldman and Morgan Stanley want to be banks, that's A-OK -- just as long as they divest their nonbanking operations.

Are there advantages to allowing banks to operate a wide selection of financial businesses? Sure, but there are also advantages to eliminating speed limits. The risk involved in both, however, makes them inadvisable.

We could call it "Glass-Steagall 2.0," or the "Gramm-Leach-Bliley Smack Down Act," or the "Putting Banks in Their Place Act of 2009." I'm happy with any name, just as long as we get it done.

I'm no fan of gold, so I couldn't help but perk up at Jim Mueller's one stock that's better than gold.

Fool contributor Matt Koppenheffer owns shares of Bank of America, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...

Read/Post Comments (7) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 04, 2009, at 4:35 PM, theHedgehog wrote:

    Well spoken. It's time for the regulators to recognize that size doesn't equate to either fiscal responsibility or lower customer costs. There is no competition left in our growing corporatocracy.

  • Report this Comment On December 04, 2009, at 5:00 PM, domili wrote:

    "Which part of this system sounds like the free market?"

    Great comment!

    I support a return to the gold standard but we can disagree on that.



  • Report this Comment On December 04, 2009, at 8:36 PM, tkell31 wrote:

    Probably one of the top five articles I've read on this website. Seems borderline criminal to allow this to go on, but given our politicians are in bed with the bankers (and our money) is it ever going to change? Nope.

  • Report this Comment On December 05, 2009, at 9:38 AM, DrRoberts1 wrote:

    Good luck whiners! The numb skulls in DC can't even do "Health Care Reform that does not further enrich the insurance companies. And you "pie in the sky" idealists think you are gonna break up the big banks? Obama just sent 30, 000 more troops as not to ruffle the Pentagon and you think he is gonna reform "The Street"? Get a life!

  • Report this Comment On December 07, 2009, at 2:01 PM, BMFPitt wrote:

    I would make two simple and effective changes if I were in charge. I think they would fix a lot.

    1) The government shall not, under any circumstance, provide funding to a private entity. The only option other than bankruptcy is a government recievership not to exceed six months, where every shareholder and bondholder is completely wiped out, only for a company that provides some service that can't be interruped.

    2) No bank which has ANY trading/insurance/etc activites shall be allowed to be FDIC insured.

  • Report this Comment On December 07, 2009, at 5:01 PM, OneLegged wrote:

    That generations of taxpayers must shoulder the risk and, by way of that, the cost of Bankers miscues is insanity. I simply can't believe there isn't more outrage from the guy on the street. This financial meltdown we are currently experiencing has drawn back the curtain on the Almighty Oz. This "banking" system is beyond broken.

  • Report this Comment On December 07, 2009, at 5:03 PM, OneLegged wrote:

    That generations of taxpayers must shoulder the risk and, by way of that, the cost of Bankers miscues is insanity. I simply can't believe there isn't more outrage from the guy on the street. This financial meltdown we are currently experiencing has drawn back the curtain on the Almighty Oz. This "banking" system is beyond broken.

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